Consolidated rules for intercompany transfers of member stock.

In general, no gain is recognized for Federal income tax purposes on the transfer of property between consolidated group members. Caution should be exercised, however, when the property involved is the stock of a consolidated member. Certain transactions (e.g., liquidations, mergers or redemptions) that eliminate a holder's tax basis in the member stock may cause the recognition of any prior deferred intercompany gain related to that member stock. Fortunately, limited elective relief may be available under Regs. Sec. 1.1502-13(f)(5)(ii) for groups willing to undo a triggering transaction that occurred in a tax year after July 11, 1995, to avoid such gain recognition.

Two recent IRS letter rulings illustrate the application of the intercompany transaction rules to transactions involving member stock.

In Letter Ruling (TAM) 9643002, the IRS ruled that the merger of three consolidated group members into another member required gain recognized and deferred on a pre-July 12, 1995 intercompany distribution of stock to be restored under former Regs. Sec' 1.1502-13(f)(1)(iv).

P served as the common parent of an affiliated group filing consolidated returns. P owned all the outstanding stock of S1; S1 owned all the outstanding stock of S2; and S2 owned all of the outstanding stock of A, B and C (the Subs). In an earlier restructuring, S2 distributed the stock of Subs to S1. The fair market value (FMV) of the Subs stock exceeded its adjusted tax basis. Accordingly, S2 recognized gain pursuant to Sec. 311 (b), which it deferred under former Temp. Regs. Sec. 1.1502-14T(a). Thereafter, S1 was liquidated into P. As a result, P owned all of the Subs stock. P later formed S3 and merged Subs into S3. The Service concluded that the merger of Subs into S3 was an event that restored the gain recognized and deferred on the intercompany distribution of the Subs stock.

Typically, deferred gains and losses of pre-July 12, 1995 transactions are not includible in taxable income until one of the restoration events described in former Regs. Sec. 1.1502-13(f) occurs. Former Regs. Sec. 1.1502-13(f)(1)(,vi) provided that, in the case of stock, deferred gain or loss is included in income on the date the stock is redeemed or becomes worthless. In general, a corporation redeems its stock when it repurchases its shares.

In the TAM, the IRS reasoned that the transfer of all of the assets of Subs to S3 in the merger gave rise to a deemed corresponding transfer of S3 stock to each Sub. Each Sub was then treated as exchanging the S3 stock with its shareholder P, for its stock, which was then canceled. Based on this deemed flow of consideration through each Sub, the Service concluded that each Sub repurchased its stock from P, and thereby redeemed its stock within the meaning of former Regs. Sec. 1.1502-13(f)(1)(vi). Consequently, the merger of Subs into S3 required the deferred gain to be taken into account by S2.

The facts and analysis in TAM 9643002 are remarkably similar to those in Letter Ruling (TAM) 9627003. In that transaction, the IRS held that the tax-free merger between consolidated group members required the restoration of a deferred gain caused by an earlier sale transaction under former Regs. Sec. 1.1502-13(f)(1)(vi). Again, the Service reasoned that, because the target member was treated as repurchasing its own shares in the deemed exchange for the acquiring member's shares, the target's shares were redeemed.

Under the current consolidated regulations, these transactions would not trigger the deferred intercompany gain related to the target's stock. The current consolidated intercompany regulations would consider the acquiring member to be a "successor" entity after the merger; thus, no triggering event would occur. However, a subsequent liquidation, redemption or disposition of S3, or an act rendering S3 worthless, could be a triggering event under both the current and former intercompany transaction regulations.

The current regulations apply to transactions that occur in a tax year after July 11, 1995, or for earlier transactions if the group timely elected to apply the current consolidated regulations retroactively. Therefore, both the transaction that gave rise to the deferred intercompany gain or loss and the triggering event must occur after July 11, 1995 for the current consolidated regulations to apply for most groups.

In TAM 9644003, the Service ruled that the merger of a consolidated group member into a partnership required gain, recognized and deferred on a pre-July 12, 1995 intercompany distribution of stock, to be restored under former Regs. Sec. 1.1502-13(f)(1)(iv).

P served as the common parent of an affiliated group filing consolidated returns. P directly owned all of the outstanding stock of S1 and Sub. In an earlier restructuring, S1 had distributed all of the outstanding stock of Sub to P. The FMV of Sub stock exceeded its adjusted tax basis. Accordingly, S1 recognized gain pursuant to Sec. 311 b), which it deferred under former Temp. Regs. Sec. 1.1502-14T(a). P later formed S2 and S3 to be partners in a new partnership and merged Sub into the partnership. The Service concluded that the merger of Sub into the partnership was an event that restored the gain recognized and deferred on the intercompany distribution of the Sub stock.

In this TAM, the Service reasoned that the transfer of all the Sub assets to the partnership in the merger gave rise to a deemed corresponding transfer of the partnership interest to Sub. Sub then was treated as exchanging the partnership interest with its shareholder, P, for its stock, which was then canceled. Based on this deemed flow of consideration through Sub, the Service concluded that Sub repurchased its stock from P, and thereby redeemed its stock within the meaning of former Regs. Sec. 1.1502-13(f)(1)(vi). Consequently, the merger of Sub into the partnership required the deferred gain to be taken into account by S1.

These transactions would trigger the deferred intercompany gain related to the target's stock under the current regulations as well. The merger of a member into a partnership is a triggering event to deferred intercompany gains related to that member's stock under the current regulations, because the member has left the consolidated group (the partnership also fails to qualify as a "successor" entity).

If the partnership was treated as a taxable association or the partnership elected to be treated as a corporation under the check-the-box regulations, the merger might not trigger the deferred intercompany gain related to the Sub stock under the current consolidated intercompany transaction regulations. In this situation, the partnership would be treated as a taxable corporation/association eligible to join a consolidated group. Thus, the merger of Sub into such a partnership would not be a triggering event, because the partnership could qualify as a "successor" entity that was a member of the consolidated group.